Description

Shares of TRM should generate a growing leveraged free cash flow of 10% to 20% per year which will be reinvested at a 20% to 30% rate of return into the foreseeable future.

TRM is the second largest independent ATM service operator in the U.S. as well as in the world with 21,672 ATMs and 24,776 photocopy machines. In full disclosure, VIC member Jay912 published a report on TRM on June, 24 2004 when the company’s shares were trading for $14.02. Jay did a good job explaining the business and the industry. Since that time, shares rallied to $25 and then proceeded to fall back down below $14. Rather than attempt to recreate Jay’s work, I will attempt to demonstrate why the company’s current share price represents a tremendous opportunity for value investors.

Share Price $15.50

Shares 13.956
Options 1.580
Option Buyback (0.581)
Diluted Shares 14.955

Market Value 231.807

Long-Term Debt 133.321
Capital Leases 3.190
Minority Interest 1.500
Shares in Moneybox plc (9.416)
Cash (2.072)
Net Inventory Trust (1.347)
Net Debt 125.176

Enterprise Value 356.984

Despite being in the seemingly simple ATM business on the surface, TRM’s financials are fairly complicated and require a significant amount of time to be fully understood. I believe that investors can more accurately value this business if they are able to overcome three major misperceptions that exist in the marketplace.

The company’s assets are ATM machines.

TRM is a service company. It makes money by servicing ATM machines placed at high-traffic retail locations. While the company has 21,672 ATMs, only a quarter of these are actually physically owned by TRM. The remainder consists of service contracts giving TRM the right to collect a recurring fee from ATMs it does not own. On these machines, TRM collects a $0.60 interchange fee anytime someone conducts a non-withdrawal transaction. In some cases, the vendor manages the vault cash, and all TRM has to do is service the machine if there is a problem. In this sense, TRM’s real assets are the service contracts associated with each machine. Withdrawals per machine, average sales per withdrawal, gross margins, and operating margins will significantly vary depending on whether or not the machine is owned by TRM or by the retailer; whether the machine is in the U.K., the U.S. or in Canada; and the relative bargaining power of the retailer. For this reason, I believe investors’ have been overly focused on margins and not focused enough on the associated cash costs or return on price paid per machine. A more accurate way of valuing TRM’s asset base is to assess the incremental free cash flow being added with each new machine.

Earnings are a poor proxy for cash flow.

A good portion of the value being created by TRM comes from the fact that GAAP depreciation overstates economic depreciation because substantially all of the costs associated with maintaining the machines are expensed.

“We have yet to find an ATM machine that we had to take out of the marketplace because of obsolescence…They seem to continue to just keep working.” – Ken Tepper, CEO

The eFund acquisition combined with the pressures of Sarbanes-Oxley significantly strained TRM’s resources. The company has incurred a number of one-time costs associated with its acquisition of eFund’s ATM portfolio. The cost savings and necessary SG&A expenditures have indeed taken longer than originally anticipated but they will eventually be realized. On the Q1 call Tepper said that he expects all of the achievable costs savings to be realized in the next six months. Given the fact that this acquisition made TRM the largest independent operator of ATM machines in the world, I think this is reasonable. The equity analysts that I have spoken with have received a number of phone calls from investors who believe the company is expensive on a P/E basis. In response, the analysts have suggested that investors focus on long-term cash flow generation rather than on short-term EPS fluctuations. In this one rare instance, I am inclined to agree with the equity analysts.

TRM still represents a compelling value even if the photocopy business continues to decline.

To put this in perspective, ATMs generated $5,894MM in EBIT while photocopiers generated $0.488MM in Q1 2005. It is hard to argue that this is not a declining business. TRM has the ability to track sales individually for each of its 24,776 machines and thus set prices accordingly in order to maximize the cash flow. To offset lower volumes, TRM has raised prices for its photocopy business from $0.06 to a little over $0.08. Additional price increases are expected to take the average price per copy to $0.12. Operating profit per machine has fallen over the last few quarters and because the photocopy business shares a good portion of the SG&A expenses with the ATM business, a number of investors incorrectly believe that if the photocopy business continues to decline, TRM would no longer present a compelling investment.

Let’s assume that the photocopy business shuts down tomorrow but we will continue to pay the associated SG&A expenses. We will therefore pull out the $3.1MM in gross profits generated by the photocopy business or $1.922MM in after-tax FCF, resulting in result in $4.529MM in quarterly FCF or an annualized yield of 8.1%. In reality, the company should be able to save some money by removing excess overhead.

Aligned Management

I have been very impressed with management. Insiders own a significant amount of stock and purchased 26,000 shares at around $16 a share in May and 114,000 at a price of $12.35 in September, 2004. 100,000 of these shares were purchased by Director Daniel Cohen who now owns 771,435 shares. CEO Ken Tepper owns 84,355 shares, COO Thomas Mann owns 66,545 shares, and Dan Tierney owns 40,131 shares.

Superior Execution

The top two accounts are The Pantry (Kangaroo Express) and Cumberland Farms (Gulf). Cumberland Farms recently renewed its contract for seven years. I called these partners and found that they spoke very highly of their relationship with TRM. They have had banks service their portfolio in the past but TRM has very little downtime. Both vendors wanted TRM to take on more machines, but TRM actually turned down some of this business because it did not meet the company’s internal ROIC requirements. Conversations with other customers and suppliers have yielded the same view of the company.

Let’s walk though the financials. Since ATM and photocopy machines tend not to be very seasonal in nature, I have assumed that Q1 2005 can be multiplied by four to get a FY 2005 run-rate. Looking at the withdrawals per ATM per day and copies per copier per day by quarter over the last two years, it appears that photocopy machines tend to do 25% to 26% and ATM machines tend do 24% to 25% of their annual volume in Q1. Since ATM’s generate the majority of TRM’s cash flows, simply multiplying by four is slightly conservative.

Q1 2005 FY 2005

EBITDA 9.700 38.800
Transitional Expenses 1.300 5.200
Adjusted EBITDA 11.000 44.000
D&A (4.900) (19.600)
Amortization of Financing Fees 0.260 1.040
EBIT 6.360 25.440
Interest Expense (2.229) (8.916)
EBT 4.131 16.524

So far we have not made any assumptions. All of the above numbers come from the company’s Q1 2005 press release. I will now assume a 38% tax rate even though TRM’s taxes are typically less than this number.

Tax Expense (1.570) (6.279)
Net Income 2.561 10.245
Normalized D&A 4.640 18.560
Operating Cash Flow 7.201 28.805

In order to calculate FCF, I will use management’s expectation of $0.5MM in maintenance capital expenditures. This may sound low, but keep in mind that all of the parts, service, and repairs associated with the machines are expensed in COGS rather than capitalized.

Maintenance Capex (0.125) (0.500)
Levered FCF 7.076 28.305
Yield 12.2%

After-Tax Interest Expense 1.382 5.528
Unlevered FCF 8.458 33.833
Yield 9.5%

These appear to be respectable cash flows for this business, but keep in mind that I have completely disregarded a number of factors that have a very high probability of further increasing FCF. These factors include:

Photocopier:

– Increased average pricing from $0.08 to $0.12, management claims that extensive testing of 50% to 100% higher prices results in only a 20% volume reduction, apparently because individual’s who go to a drug store to make three to four copies of a document tend not to be overly sensitive to prices

– Increased pricing for all legal-sized copies

ATM:

– Cost savings as the legacy owned portfolio is switched to eFund’s lower processing costs

– Announced deals with U.S. casinos which management believes will add 1.3 million transactions per year at an average withdrawal fee of $3

– Potentially higher operating rates now that the U.K. ATM portfolio has been fully upgraded

– Announced price increase from £1.50 to £1.75 on 4,000 U.K. ATMs

– Any additional price increases on U.S. ATMs

– Any additional organic or acquisition related growth in the underlying ATM portfolio

General:

– TRM is really building out a global service network, capable of fixing any machine operating at a retail location. The larger this network becomes, and thus the shorter the distance a service technician must drive between two locations, the lower the costs associated with adding new machines to the service network. I believe that TRM is already the low cost provider and thus the company can easily add incremental service contracts for bank-owned ATMs, other ATM ISOs, Coinstar machines, etc.

– There is a chance that the photocopy business is turned around. Tepper suggested on the last call that their goal with the new price changes is to get the photocopy business back to Q1 2004 levels. If it can achieve prior levels of more than $4MM in EBITDA, annual FCF would be $8MM higher.

– TRM can redeploy capital at a very high cash-on-cash rate of return. In some cases, new machines pay for themselves in one to two years. I do no see any reason for this reinvestment opportunity not be available in the foreseeable future.

“When we are able to acquire and deploy a new machine, our payback time on that investment can be as short as 13 months.” – Ken Tepper, CEO

INDUSTRY VIEW

The ATM industry is rapidly consolidating into the hands of a few ISOs as the banks do their best to get out of the business. ATM networks are growing rapidly in other countries and Mexico is expected to begin surcharging on June 15. The U.K. has had some political battles about consumers having to pay to get their own cash recently but I am hearing that ATM machines are operating close to normal rates. India and Australia are also evolving rapidly. A good industry site is: www.atmmarketplace.com. In the long-term, TRMM should be able to use the business experience gained from the U.S. in other markets.

COMPANY HISTORY

1981 – TRM founded in Pendleton, Oregon
1996 – ETFs allowed owners to surcharge for cash withdrawals
3/9/04 – Reported Q4 earnings of $2MM
4/2/04 – Purchased Inkas Financial Corp. which had 450 ATMs
4/23/04 – Signed agreement with Shell UK to deploy 250 ATMs
4/29/04 – Reported Q1 earnings of $2.5M
6/17/04 – Acquired Mighty Cash Financial
7/9/04 – Acquired 350 ATMs in the UK
7/12/04 – Approved to be traded on the NASDAQ
8/10/04 – Reported Q2 earnings of $2.7MM
8/26/04 – Public offering of 4.5M shares at $11.00 a share
8/27/04 – Follow-on offering at $11.00, lead by FBR and co-managed by Piper Jaffray
9/20/04 – Purchased eFunds’s ATM portfolio
9/23/04 – Sold of 675,000 shares for $7.0M to underwriters as over-allotment option
11/2/04 – Received credit rating of B2 from Moody’s and B+ from Standard and Poor’s 11/12/04 – Reported Q3 earnings of $2.2MM
11/22/04 – Closed eFunds acquisition
12/14/04 – Contract to operate photocopiers in 1,549 Eckerd locations
12/15/04 – Announced three-year contract for Hard Rock Casinos in the U.K.
3/3/05 – Reported Q4 earnings of $1.7MM

Catalyst

-Exclusion of one-time costs, strong Q2 and Q3
-Further cost savings
-Additional acquisitions
-Additional contract announcements